Executive Summary:
Private investments have long been a tool of institutional investors such as Yale University.[1]
Building a portfolio that includes a dedicated allocation to private capital investments requires careful planning and a long-term focus.
Our proprietary Institutional Portfolio Manager analytical tool has the capability to model a variety of complex scenarios as they build a portfolio of private capital investments.
“If you asked the public what they wanted, they would have said a faster horse.”
– Henry Ford
Those in endowment management most certainly have heard of legendary investor, David Swenson. He served as the Chief Investment Officer of the Yale University Endowment from 1985 until his passing in 2021. Under Swensen's leadership, the Yale Endowment saw remarkable growth. From the time he took over in 1985 to around 2020, the endowment grew from about $1 billion to over $30 billion. His management yielded an annualized return of approximately 13.1% from 1985 to 2020, significantly outperforming broader market benchmarks. A large part of Swenson’s success may be attributed to his willingness to look significantly different than peers, to take a very long-term view, and to incorporate a heavy allocation to private and alternative investments. This approach today is often referred to as the “Yale Model” or the “Endowment Model” of portfolio management.[2]
Swenson and Yale helped to formalize the private investment industry, and while they may sound opaque or provocative, private investments are often not too dissimilar from public ones in their base characteristics. For example, an investor who owns a publicly-traded stock or a privately held business has the right to their proportionate share of company assets and future cash flows in either example. The same is true for an owner of a publicly-traded real estate investment trust and the owner of a portfolio of buildings held privately. Public companies offer more liquidity than private ones, but being publicly-traded also comes with greater exposure to market volatility and price swings. Public companies have better transparency as they are subject to specific and standardized reporting requirements. Owners of private companies often have greater ability to drive value and operational improvements than passive owners of publicly-traded stock. And, the opportunity set for private investors is significantly greater, often with better pricing and lower competition; there are approximately 665,000 private companies in the US and only 6,000 publicly-traded ones.[3] Due to these attributes, private investments may provide portfolios with enhanced long-term returns relative to public markets. And, larger institutions with potentially greater sophistication and larger allocations to alternative and private investments have historically outperformed their smaller peers.[4]
Source: Pitchbook for private capital indices, Morningstar for public market indices.
Date as of December 31, 2023
Data based on Pitchbook private capital manager categories and quarterly returns.
Private Equity comprised of Buyout, Growth, Restructuring, and Diversified categories.
Real Estate comprised of Value-Add, Opportunistic, Core, Core-Plus, and Distressed
Private Debt comprised of Direct Lending, Distressed Debt, Mezzanine Financing, Bridge Financing, Special Situations, Infrastructure Debt, Real Estate Debt, and Venture Debt
Managing Private Investment Cash Flows
Institutional investment portfolios often have multiple types of cash flows that can present planning challenges for portfolio managers. In addition to regular distributions in support of the organization, the portfolio may receive periodic inflows from gifts or excess working capital as well as extra outflows during periods of market stress (if the organization needs to dip into reserves). Internal to the portfolio, another source of difficult-to-predict cash flows are those that result from commitments to private investments.
Commitments to private investment strategies are made with the expectation that they will provide returns in excess of comparable public market strategies. Of course, seeking additional return in private markets presents additional complexity and risk, mostly in the form of illiquidity. Many private investment funds, most often in asset classes such as real estate, private equity, private debt, and venture capital require investors to make commitments in fixed dollar amounts, then the general partner (the manager) has discretion to call some or all of the commitment in order to purchase and support investments made within the fund. In these structures, general partners typically have contractual windows of time during which they are allowed to call capital from limited partner commitments (often 3-5 years from the commitment date), but within these windows the size and timing of cash flows can be highly unpredictable, and are typically based on the pace at which the general partner identifies and consummates underlying investments as well as the overall economic environment (for example, capital calls and distributions often both slow during periods of economic stress as transaction volumes decline). And, since commitments are made in fixed dollars and invested by the underlying general partner sporadically over time, this creates cash flow and risk management challenges for institutional portfolio managers who must account for a litany of other variables such as external portfolio cash flows and the volatility of other portfolio investments such as public equities.
For most institutional portfolios that invest in private strategies, they typically have a large balance to existing investments (“called capital”) that is readily reported as an asset on the portfolio’s position statement and the organization’s balance sheet. However, related to that invested private capital balance is an unfunded commitment made at some point in the past that is frequently not listed as a liability on either the portfolio’s position statement nor the organization’s financial statements. Unfunded commitments may represent a shadow source of risk that should be better tracked and understood by institutional portfolio managers. This risk was put into the spotlight during the 2008-2009 financial crisis as several prestigious university endowments, including Harvard University, experienced a cash crunch and were forced to sell very illiquid investments at steep discounts.[5] The crisis revealed vulnerabilities in many endowments' strategies, especially those with significant allocations to illiquid assets like private equity, hedge funds, and real assets.
Building a mature private capital program cannot be done overnight. It is recommended that institutional portfolio managers and fiduciaries build their private capital allocation over at least 3-5 years, but it is highly likely that market and economic conditions along the way will cause the path toward building to private capital targets to be anything but smooth.
Given that private capital commitments are typically made in fixed dollar amounts and given that private capital investments typically experience slower and more shallow declines in value during periods of market stress (a concept called “lagged beta”[6]), this can throw the portfolio “off plan” very quickly. For example, $20 million of private capital commitments represents 20% of a $100m portfolio, but if that portfolio declines in value to $70 million because of market forces or unforeseen liquidity needs, those private capital commitments remain at $20 million, but now represent 29% of the portfolio, potentially reducing flexibility and pushing the portfolio toward an intolerable level of expected risk.
In this environment, portfolio managers a left with risky choices. For example, they may be forced to slow or halt new private capital commitments if overall private capital exposure becomes too large. This is problematic because the best private capital vintage years may come from those that began during periods of market stress. In other words, the portfolio may not have the liquidity and flexibility to continue on its private capital pacing plan and may subsequently miss the highest returning vintages of funds. The portfolio manager may also choose to run for an extended period of time with private capital exposure that is greater than the original target, which may be limit flexibility to rebalance into liquid asset classes such as stocks or to meet obligations external to the portfolio.
The broader point is that institutional portfolio managers and fiduciaries must balance planning for the unexpected while not being overly conservative in the face of all the potential risks that may befall the portfolio. Institutions seeking to build a private capital program should plan a long-term glidepath that includes consistent new commitments over at least 3-5 years.
With our proprietary Institutional Portfolio Manager analytical tool, we guide our clients toward a private capital glidepath that can withstand adverse market environments tailored for their specific portfolio and goals. If you would like to learn more about this tool and have your own portfolio analyzed, please contact us.
[2] Casavecchia, L. (2008). David F. Swensen and the Yale Model of Endowment Management. Journal of Portfolio Management, 34(3), 23-28
[3] Private companies are those with more than 20 employees according to the US Census Bureau published March 2023. Public companies represented by total listings on the New York Stock Exchange and the NASDAQ as of February 2023.
[4] Source: 2023 NACUBO-TIAA Study of Endowments.
All data are dollar-weighted. Alternative strategies include: marketable alternatives (hedge funds), private equity, private venture capital and real assets. Private debt included in Fixed Income.
[5] McDonald, D., & Kambourov, D. (2010). The Wall Street Journal. "Harvard Swaps Are Sobering Lesson for Universities."
[6] Anson, M. J. P. (2002). Private Equity Returns and Disclosure Around the World. Journal of International Money and Finance, 21(5), 727-754.
Past performance may not be representative of future results. All investments are subject to loss. Forecasts regarding the market or economy are subject to a wide range of possible outcomes. The views presented in this market update may prove to be inaccurate for a variety of factors. These views are as of the date listed above and are subject to change based on changes in fundamental economic or market-related data. The ETFs presented above are not intended to be benchmarks for performance. Rather, they are intended to be demonstrative of a particular sector or segment the investment universe discussed. Each ETF was selected as opposed to an index to more accurately reflect what an investor might experience. There are other ETFs or indices that might be representative of the same spaces. However, we believe the ones shown are sufficiently representative to assist us in explaining our investment thesis. Please contact your Advisor in order to complete an updated risk assessment to ensure that your investment allocation is appropriate.
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